Greasing Palms

Political corruption is a potential risk for investors and financial intermediaries.

This paper provides evidence of a new and unique role that that financial institutions play in mitigating the costs of corruption.

The upside is that specialized financial institutions sell insurance contracts to outsource the risks of corruption from bonds.

Theory and evidence suggest that political corruption is costly because it slows financial and economic growth and development. But how exactly?

In a study by¬†Alexander W.¬†Butler, a professor of finance at Rice Business,¬†and two co-authors, the municipal bond market provides a laboratory to show precisely how political corruption affects the interactions between governments, financial intermediaries (e.g. banks and insurers) and investors.

States within the U.S. issue municipal bonds to fund local investments such as new schools and transportation projects. ¬†Municipal bond markets provide an ideal research setting due to the availability of detailed data, which include the credit risk and pricing of bonds, the underwriting services and fees and the quality of financial intermediaries.

Corruption convictions per capita of local, state and federal officials measure just how corrupt a state is. Notoriously corrupt states such as Louisiana, Mississippi and Illinois have the highest conviction rates, whereas Nebraska, Utah and New Hampshire have the lowest.¬† For example, the citizens of Illinois have elected three governors, one cabinet member, four state senators and three state representatives who have been formally convicted and jailed due to federal corruption offenses, including the conviction of Rod Blagojevich.

The authors use the fact that some states are more politically corrupt than others to study how political corruption drives differences across municipal bond markets. Their results answer four questions that provide insight into how political corruption affects financial markets:

Does political corruption affect credit risk?

Does political corruption affect the pricing of investments?

Does political corruption affect the service fees that investment banks charge?

Does political integrity affect issuers‚Äô choice of financial institutions?

The paper shows that bonds issued by highly corrupt states have significantly higher risk, in the form of lower bond ratings, than those issued by less corrupt states. Furthermore, corruption comes at a price.¬† Politically corrupt states must pay significantly higher rates of interest, or yields, to entice investors to buy their bonds. These higher interest rates make it more expensive for states to fund local investment projects that benefit state residents.

Naturally, specialist financial institutions have emerged to establish a price for political risk. These bond-insuring institutions evaluate the risks of political corruption and sell products called credit enhancements, which separate out the corruption component of a bond‚Äôs overall risk. Corrupt states are able to undo completely the negative effects of corruption on their bond prices by purchasing credit enhancements. The authors find that corrupt states are willing to pay the price, via credit enhancements, to make their bonds look like those of their less corrupt neighbors.

But corrupt states cannot buy their way out of all negative consequences of corruption. Investment banks provide underwriting services to bond issuers and charge a fee for these services. The authors find that issuers in corrupt states use lower quality investment banks. The authors suggest that higher quality investment banks are unwilling to risk their reputations by underwriting risky bonds in politically corrupt states, regardless of the price that corrupt states would be willing to pay for their services. Corruption hurts these states by potentially reducing access to better connected, high quality investment banks.

Investment banks themselves have a history of corruption. Specifically, investment banks have been infamous for bid rigging, bribery and other illegal activities when competing for lucrative underwriting contracts. The spoils went to investment banks that made the most substantial contributions to politicians. Investment banks and politicians alike were happy with this ‚Äúpay-to-play‚ÄĚ arrangement. When the SEC enacted rules to limit this behavior, an investment bank in Alabama filed an (ultimately unsuccessful) lawsuit against the SEC. The authors find that when investment banks made campaign contributions to legislators in order to win underwriting business, the investment banks charged higher underwriting fees for these sweetheart municipal bond deals, which were allocated on the basis of favoritism.

The results show that state corruption and political connections impede financial and economic development by increasing investment risk and bond interest payments and reducing access to high quality financial institutions. Specialized financial institutions allow issuers to purchase credit enhancements to remove corruption-induced risk from bond yields. Credit enhancements play an important role in alleviating the economic damage that corruption can cause. But citizens pay for the crimes of their leaders. Credit enhancements and inflated ‚Äúpay-to-play‚ÄĚ underwriting fees to investment banks are paid from state coffers and ultimately make investment in public projects more expensive in corrupt states.

Alexander W. Butler¬†is a finance professor at Jones Graduate School of Business at Rice University.